[Newsphopick=Kingsley Lim] When it comes to investing, it is typically the case that institutional investors are assumed to have every advantage to the retail investor. With brilliant brains, Bloomberg terminals, and the dry powder to invest large sums in companies, these mutual funds or hedge funds typically manage billions of dollars - and they do so to gain economies of scale.
The profitability of an asset management business is based on the total assets under management and the performance. Most of the time, mutual funds do not outperform the relevant benchmark. So the question is why would you want to put your hard earned money into a mutual fund when you can put it into an index fund, which at least tracks the benchmark?
The hard truth is that many asset management firms including hedge funds are incentivised to grow the assets under management. The larger the assets under management, the greater the profits of the firm. If the management fee is 1.5%, the asset management firm will earn $1.5 million for every hundred million in assets managed by the company.
If the asset management firm manages $200 million, then the management fee it earns for that year is $3 million. $3 million could very well support a portfolio manager and a small team of support staff, comprising of analysts and administrative functions.
Hence, without performing well, portfolio managers could collect their salary working for an asset management firm without having to do very much. After all, most do not beat their relevant benchmarks.
Another reason asset management firms do not outperform is because so many of them chase the same stocks. And typically, because, they are managing so much money, they would have no choice but to invest in companies that are considered large caps. Imagine a fund manager having $1 billion in assets under management. He may want to partake in 20 opportunities, and doing so means that he would have to allocate $50 million to each opportunity.
Can a fund manager put $50 million into a company with a market capitalisation of $50 million? Clearly, the answer is no. Can a fund manager deploy $50 million into a company with a market capitalisation of $100 million?
Similarly, that answer is likely a no. That is because doing so would mean that he has to own 50% of that company, meaning that he is now a controlling shareholder. Selling out means that he would have to find buyers that would purchase the entire company. This is remote but it can happen. However, by and large, fund managers do not have the mandate to do that.
For most funds, the mandate is to invest in large companies that have liquidity. The problem is this – large caps have a large analyst following and more likely than not, these companies will be fairly valued by the markets. For most funds managing $1 billion, chances are that $50 million will be deployed into a company with a market capitalisation of at least $2 billion.
Where is the retail investor advantage then? When one is managing small sums of money, it is easier to get in and out of the markets. A small retail investor could invest in stocks with a market capitalisation of $200 million and less, and scour stocks which are neglected and left untouched by the investment community.
After all, isn’t it the case the retail investors typically invest in large cap, ‘blue chip’ companies as well? That is because most retail investors rely on brokerage reports generated by brokerage firms that want to earn the maximum amount of commissions. That being the case, frequent research reports are generated to encourage frequent trading as that means commissions for the brokerage firm.
Hence, retail investors who rely on brokerage reports are actually retarding their own investment performance. When one relies on brokerage reports, one becomes a part of the ‘herd’ that moves the markets. There is a lot of incentive-caused bias in the system and it perpetuates to the small investor.
What should retail investors do then? Well, one could research small and ignored stocks with market capitalisations of $500 million or less. Typically, one would be able to find more valuable opportunities than when investing in large companies, which are well followed by analysts.
Sometimes, you get profitable small companies which have been beaten down and trading at less than their respective tangible book values when you look into small companies. That is a good thing because small stocks are typically irrationally beaten down to the point where it makes no sense. Some of these companies trade at less than the liquidation value and this is an example of irrationality in the price of small stocks.
Retail investors can take advantage of that and wait for mean reversion to occur. To small investors out there, do not destroy your advantage!